(Editor’s note: Petra Loer and Kurtis Handa are Managing Directors in WTAS’ Valuation Services practice. They submitted this story to VentureBeat.)

Some entrepreneurs consider 409A valuations a necessary evil.  But too many aren’t particularly familiar with this particular section of the corporate tax code. And while we realize tax law might not be red-hot cocktail party conversation, it’s something that should be top of mind for start-up owners.

409A valuations are most commonly performed to assist companies with setting the strike price for their employee stock options, which needs to be at or above fair market value.  The most common questions surrounding those are: “Do I really need a valuation?,” “How do I select an appraiser and why does it cost so much?” and our personal favorite “Why is my common stock worth so much?”

Let’s explore each one.

Do I really need a valuation? – Internal Revenue Code Section 409A regulates the treatment of “nonqualified deferred compensation” paid by a “service recipient” to a “service provider” for federal income tax purposes.  Nonqualified deferred compensation can take the form of stock options, stock appreciation rights, or similar instruments.  Here’s what you’ll need to consider when you’re determining the need for a valuation:

  • The fair market value must be determined using “reasonable application of a reasonable valuation method.”
  • A valuation needs to be performed by someone who is qualified (based on their knowledge, training, experience, etc.).  In most cases, companies choose to hire outside appraisal firms to meet this requirement.
  • The valuation needs to be updated at least every 12 months, or more frequently if significant changes occur in the business between grant dates (such as new rounds of financing).

If your company fails to comply with 409A, your employees will be personally liable for immediate taxation – plus a 20 percent penalty tax, and potential interest payments.

How do I select an appraiser and why does it cost so much? – You’ll need the appraiser in order to comply with the first two points above. As for the expense, keep in mind that properly performing an appraisal and considering all of the relevant factors can take a considerable amount of time.

As you look for the right person, here are a few questions you should ask:

  • What methods would you use to value the common stock? If there is a recent arms-length round of financing, the appraiser may be able to rely on the round to deduce common stock value.  The appraiser should consider using an option-pricing model (i.e., Black-Scholes, lattice, or Monte Carlo – depending on the complexity of your capital structure), the Probability Weighted Expected Return Model (or “PWERM”), or the current value method (which is only appropriate in limited circumstances).  In terms of fees, relying on a round generally costs less, and fees for companies with complex capital structures are generally more.
  • How do you support your concluded marketability discount? The IRS will look for evidence that your appraiser considered factors specific to the company and data such as restricted stock studies, not just quantitative models.
  • Have you been successfully reviewed by auditors?
  • Can your valuation be used for both tax and financial reporting purposes?

Why is my common stock worth so much? – Our clients often want to understand what types of factors influence the value of their common stock.  As one would expect, any factor that increases the value of the overall company increases the value of the common stock.  However, there are other influential factors as well:

  • Preferred stock participation feature and dividends:  Most preferred shares contain a conversion option that allows the owner to convert his/her preferred shares into common shares.  Some preferred shares, however, have a participation feature allowing them to share in any upside with the common shares without the exercise of the embedded conversion rights. In other words, they get their cake and eat it too.  The presence of this type of participation feature ultimately increases the value of the preferred shares and reduces the value of the common shares.  The presence of preferred cumulative dividends would also reduce common stock value.
  • Sale/transfer restrictions: The presence of certain sale/transfer restrictions associated with the company’s common stock will reduce the stock’s attractiveness and, therefore, reduce its value.
  • Transactions in the company’s stock:  Increasingly, private company shares are being traded in the secondary market.  If a recent transaction exists, the appraiser may need to consider this value in determining the fair market value of the stock, depending on the circumstances of the transaction (like block size, buyer/seller motivation, availability of information, etc.).

Private company common stock virtually always has value; therefore, obtaining a defensible appraisal is an important step in potentially saving you from unnecessary IRS challenges and saving your employees from unexpected tax and penalties.

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